It’s like an annual high school final exam to determine whether you passed or get scolded by your mom, but you are a bank.

Since the fallout of Bank Century in 2008, every business people and regulators put an eye on the prudentiality of banking business.
Bank is considered to have a systemic impact on economy so that bank endurance towards external shocks has to be tested. One of the most widespread analysis is stress testing.

What is a stress test?

Stress test is an examination on bank capital adequacy to withstand the losses or potential losses during an unfavorable business scenario, usually tested in a worldwide crisis condition. The stress test commonly performed by governmental regulatory bodies or bank internal examiner. For certain developed regions like Europe or America, stress test is a mandatory for selected top tier banks. European Banking Authority (EBA) is one of the most renowned governmental regulatory bodies that arrange the stress test for European banks.

What is the importance of passing the tests?

Passing the stress test means that the bank has enough capital buffer to absorb a reasonable amount of loss and complies with the statutory capital requirements. For investors, stress test results determine whether a bank can increase the dividends payout to shareholder. Depositors care enough because passing the stress test means that their money is in the safe hand. For bank executives, stress test results add more credibility and confidence in exercising future strategic corporate actions.

Scenario Building

The first pillar of stress testing is scenario building. There are two scenarios that should be built; baseline scenario and adverse scenario. Baseline scenario is a benchmark or reference condition when there is no financial disturbance happened. Adverse scenario reflects the macroeconomic condition when an economy going through a crisis or financial turbulence. The forecast should be represented in 3 years for each scenario to grab the delayed shocks impact within the upcoming years.

Mapping risks to scenarios

According to European Central Bank (ECB) Macro Stress Testing Framework, the general foundation for any stress testing exercise, be it top-down or bottom-up approach, is a set of macro-financial risks that could have a bearing on the resilience of banking system (or other financial institutions being stressed). There are at least 5 main risks that should be anticipated :

Credit Risks

Market Risks

Securitization

Sovereign

Funding Risk

Balance Sheet Model

After mapping risks to scenarios, variables related to the macroeconomic condition should be determined. The variables significance will vary depend on the business environment and other macroeconomic condition that are currently occurring in the country where the bank is located. Some common examples would be unemployment rate, equity market crash, GDP falls, interest rate, and commodity prices.

The selected variables then tested towards the bank balance sheet. The magnitude of changes in bank balance sheet then considered as the determinants. If a bank’s capital ratio was projected to fall below the 4.5% CET-1 risk-weighted capital ratio or 3% tier 1 leverage ratio in the stress test, there is a strong presumption that the examiner (governmental regulatory buddies or private examiner) would suggest the bank to take action to strengthen its capital position over a period of time.